MONGOLIAN PRIVATE EQUITY FUND FEASIBILITY STUDY

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Economic Policy Reform

Open Society Forum

and Competitiveness Project

MONGOLIAN PRIVATE EQUITY FUND FEASIBILITY STUDY

October 2004 Ulaanbaatar

USAID Contract No. 438-C-00-03-00021-00

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Project: Mongolia Economic Policy Reform and Competitiveness Project (EPRC) Report title: Mongolian Private Equity Fund Feasibility Study

Main author: Dennis Grubb

Contract No. 438-C-00-03-00021-00

Submitted by: EPRC Project/Chemonics International Inc., Tavan Bogd Plaza, Second Floor, Eronkhii Said Amar Street, Sukhbaatar District, Ulaanbaatar, Mongolia

Telephone and fax: (976) 11 32 13 75 Fax: (976) 11 32 78 25 Contact: Fernando Bertoli, Chief of Party

E-mail address: fbertoli@eprc-chemonics.biz

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ABBREVIATIONS

ADB Asian Development Bank BOM Bank of Mongolia CEO Chief Executive Officer

EBRD European Bank for Reconstruction and Development EPRC Economic Policy Reform & Competitiveness Project GDNT General Department of National Taxation

GDP Gross Domestic Product GP General Partner

GTZ German Development Agency

IAFRS International Accounting and Financial Reporting Standards IFC International Finance Corporation

IFI International Financial Institution IPO Initial Public Offering

IRR Internal Rate of Return

JICA Japanese International Cooperation Agency JSC Joint Stock Company

KFW KFW Development Bank LLC Limited Liability Company LP Limited Partner

MNCCI Mongolian National Chamber of Commerce and Industry MNT Mongolian National Tugrug

MoFE Ministry of Finance and Economy MSE Mongolian Stock Exchange

MSEC Mongolian Securities and Exchange Commission

MT Mongolian Telecom

NBER National Bureau of Economic Research NBFI Non-Bank Financial Institution

NGO Non-Government Organization NSO National Statistics Office OSF Open Society Forum

SME Small and Medium Enterprises

USAID United States Agency for International Development USD United States Dollar

VAT Value added tax

WTO World Trade Organization

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TABLE OF CONTENTS

ABBREVIATIONS...i

EXECUTIVE SUMMARY ...i

SECTION I: INTRODUCTION, PURPOSE, AND OBJECTIVES ...1

A. Introduction ...1

B. Purpose and objectives ...1

SECTION II: STAGES FOR THE ESTABLISHMENT OF A PRIVATE EQUITY FUND IN MONGOLIA: A ROAD MAP ...1

SECTION III: CONCEPT OF PRIVATE EQUITY IN DEVELOPING COUNTRIES ...1

A. Fund structure ...1

B. Funding sources...1

C. Types of investments ...1

D. Exiting ...2

SECTION IV: COUNTRY RISK AND COUNTRY PROFILE ...1

A. Mongolian opportunity ...1

B. Mongolia’s challenges...1

C. Economic growth ...2

D. Business environment...2

E. Conclusion ...3

SECTION V: INVESTMENT OPPORTUNITIES: PRELIMINARY ANALYSIS OF SECTORS, POTENTIAL TRANSACTIONS AND DEAL FLOW ...1

A. Sector Analysis ...1

B. Companies and deal flow...3

C. Due diligence process required for next stage...5

D. Financial analysis requirements...5

E. Investment risks ...6

F. Conclusions...7

SECTION VI: POTENTIAL FUND INVESTORS: PRELIMINARY ANALYSIS OF THEIR REQUIREMENTS AND INTEREST ...1

A. Investment objectives...1

B. Interest to invest in private equity...1

C. Capital availability for private equity investments ...2

D. Systemic risks (the Mongolian Stock Exchange) ...2

E. IRR and expected returns ...3

F. Conclusions...4

SECTION VII: MONGOLIA’S REGULATORY ENVIRONMENT: INITIAL CONSIDERATIONS ...1

A. Company Law of 1999 ...1

B. Securities Law of 2002 ...1

C. Accounting and Reporting...1

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D. Legal matters and the rule of law ...2

E. Capital markets ...2

F. Corporate governance...2

G. Tax considerations...3

H. Conclusions ...3

SECTION VIII: CONCLUSIONS AND RECOMMENDATIONS ...1

ANNEX A: CONCEPT- PRIVATE EQUITY IN DEVELOPING COUNTRIES ...1

ANNEX B: IN-COUNTRY MEETINGS AND PRESENTATIONS ...1

ANNEX C: PRIVATE EQUITY FUND CASES ...1

ANNEX D: COUNTRY COMPARISONS ...1

ANNEX E: PRIVATE EQUITY COMPANY QUESTIONNAIRE...1

ANNEX F: PRIVATE EQUITY INVESTOR QUESTIONNAIRE...1

ANNEX G: HYPOTHETICAL SOFTWARE COMPANY...1

REFERENCES ...1

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EXECUTIVE SUMMARY

The purpose of the study was to conduct an initial feasibility analysis for the potential establishment of a local private equity venture capital fund to assist high potential enterprises in Mongolia. The results were achieved as a result of on-site interviews with fifty one (51) private sector companies, IFIs, NGOs and interested private sector parties during the period September 13-October 16, 2004. The feasibility analysis was designed to address four broad areas of concern:

1. Deal flow. Gather initial data on potential deal flow of transactions that a local private equity fund may engage in; in particular, is there a sufficient number of companies and ventures with high-growth potential that could yield competitive returns to the fund and benefit from equity and quasi-equity investments

2. Fund capitalization. Canvass potential investors—individuals and institutional—for interest in capitalizing the fund, assessing their expectations for rates of return, risk perceptions and risk mitigation measures, preferences for sectors, size of investment, term, and exit strategies

3. Grant-funded technical assistance fund (TAF). Assess donors and international financial institutions’ (IFIs) perceptions and interest in contributing to the establishment of a companion, grant-funded TAF to prepare companies for fund equity investments, provide assistance in transaction structuring, supervise fund investments, assist invested companies with execution, and exit strategies

4. Preliminary analysis of the legal and regulatory environment and fund design requirements. If, and only if the first three objectives yield reasonably satisfactory results, provide an initial assessment of the legal and regulatory environment and fund design requirements.

Based on the interviews and analyses conducted, the team draws the following conclusions:

1. There is a high degree of interest from private local investors, IFIs, donors, the financial community, and local entrepreneurs in a private equity venture capital fund 2. Forty-three percent of the 47 companies interviewed manifested interest in private

equity financing

3. A contingent commitment of USD 2m to capitalize the fund was obtained from a respected local investor and the Asian Development Bank initiated its interval review process to become an anchor investor in the fund; ADB typically commits no more than 25% of the capital of a fund but can possibly consider higher commitments

4. Results from the preliminary assessment of deal flow are encouragingly positive but further due diligence will be required in the next stage to determine the size and quality of a potential pipeline of transactions capable of returning commercially competitive returns to local investors

5. Similarly, further canvassing of local investors’ concrete commitments, terms and rates of return expectations will need to be conducted in the next stage

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Economic Policy Reform and Competitiveness Project

Executive Summary - Page ii Mongolian Private Equity Fund Feasibility Study

6. The lack of reliable and readily available data on sector and company performance and ratings, not unusual in developing economies, required a methodology to approach the building of a database of companies; this unavailability of company data will represent a challenge for the future analysis of the pipeline and deal flow

7. Exit strategy for the fund investments remains a high risk, considering a non- functional stock exchange; the fund will have to consider use of a broader array of well-known investment vehicles to manage this risk: quasi-equity investments, royalty schemes, etc.

8. Legal and regulatory constraints of the Company Law, Securities Law, MSE functions and structure of ownership, use and enforcement of International Accounting and Financial Reporting Standards (IAFRS) and reporting requirements will need to be addressed to improve corporate governance and minimize risks to investors and shareholders

9. Given the initial and preliminary size of the fund, estimated at USD 10-12m, and the conditions of the business environment, a grant-financed technical assistance component will be required to prepare companies for investment, help them execute their business expansion plans funded by the equity infusion and deliver commercial returns to investors

10. There was general consensus on the requirements of success for the equity fund: it must operate as closely to commercial private equity funds as possible, be managed by professional portfolio managers, have IFIs as anchor investors, and become eventually self-sustainable from fees realized upon successful exits from investments under management.

The main recommendations are summarized as follows:

Recommendation # 1: Results of this first assessment warrant proceeding with a second stage in the feasibility analysis for the establishment of a local private equity venture capital fund in Mongolia.

Recommendation # 2: Terms of reference for the next stage of the feasibility analysis should be prepared to focus, inter alia, on the following:

• Develop more detailed analysis of sectors, company profiles, pipeline (size and returns) of potential transactions for potential consideration by the fund

• Carry out due diligence of potential companies, sectors, and transactions: financial analyses, valuations, financial projections, expected IRRs, and risk assessment

• If findings from this stage warrant it, specify and quantify initial fund design requirements such as expected size, investment strategy, and investment vehicles

• Similarly, if findings are favorable, develop recommendations for the structure and management of a grant-funded technical assistance component that would build upon current capabilities and structures of existing business development projects such as, among others, the Enterprise Restructuring Project and EPRC

• Develop concrete proposals to address corporate governance issues, tax considerations, capital markets functioning, accounting standards, and financial disclosures.

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Mongolian Private Equity Fund Feasibility Study Executive Summary - Page iii

Recommendation # 3: Conduct the second stage of analysis during the first quarter of 2005 with continued funding as approved by the Open Society Forum Board of Directors, potential commitments of USAID through the EPRC Project, and potential continued involvement of Mongolia Links Co. Ltd. Given the interest manifested by the Asian Development Bank, this broad initial partnership can be expanded to include other relevant entities interested in participating in the fund.

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SECTION I: INTRODUCTION, PURPOSE, AND OBJECTIVES

A. Introduction

Among transition economies, and more broadly among lower GDP per capita countries, Mongolia has achieved remarkable progress in setting the foundations for a democratic and open-market economy. In an otherwise bleak Central Asian landscape, and sandwiched between two powerful neighbors, the country stands out for the rapidity in implementing reforms that set the basis for a pluralistic and democratic society.

With the most difficult tasks of transition now largely completed, Mongolia needs to build on the foundations for sustainable, broad-based, equitable, private-sector-led economic growth and solidify the social and political achievements of the past to avoid setbacks and reversals.

Competitive Mongolian businesses will be the core building blocks of such foundation.

As Mongolia transforms into a market-oriented economy, privatizes state-owned enterprises, and integrates more closely to world economy, a nascent private sector is beginning to take advantage of business opportunities. Emerging private companies are beginning to weave the foundations of a market-oriented economy that must provide jobs to sustain the achievements of a peaceful political transition.

Two factors limiting growth of these emerging companies are market-oriented business know- how coupled with access to medium-term capital at competitive rates. An emerging consensus exists among seasoned observers of and protagonists in this transformation that the environment might be ready for a modest local equity and quasi equity privately managed fund. Such fund would seek competitive returns for its investors but be coupled with a grant- financed technical assistance fund to help disseminate and execute best business practices among pre-investment and invested companies.

This feasibility analysis has its origins in discussions and conclusions reached with seasoned local observers and practitioners by the Open Society Forum (OSF) and the USAID-funded Economic Policy Reform and Competitiveness Project (EPRC). The study was conducted during 13 September and 16 October 2004 with financing from EPRC, OSF, and Mongolia Links Co. Ltd. Mr Dennis Grubb, Managing Director, Invest Asia Ltd. acted as team leader with assistance from Ms Ashidmaa Dashnyam, Finance and Business Specialist, EPRC, Ms Munkhsoyol Baatarjav, Project Manager, OSF, and Mr. Enkhbayar Bayartogtokh on secondment from Mongolia Links Co. Ltd. and Ms Ileana Teodorescu, Financial Analyst in Bucharest, Romania.

B. Purpose and objectives

The purpose of the study was to conduct an initial feasibility analysis for the potential establishment of a local private equity venture capital fund to assist high potential enterprises in Mongolia. The feasibility analysis was designed to address four broad areas of concern:

1. Deal flow. Gather initial data on potential deal flow of transactions that a local private equity fund may engage in; in particular, is there a sufficient number of companies and ventures with high-growth potential that could yield competitive returns to the fund and benefit from equity and quasi-equity investments

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Section I - Page 2 Mongolian Private Equity Fund Feasibility Study

2. Fund capitalization. Canvass potential investors—individuals and institutional—for interest in capitalizing the fund, assessing their expectations for rates of return, risk perceptions and risk mitigation measures, preferences for sectors, size of investment, term, and exit strategies

3. Grant-funded technical assistance fund (TAF). Assess donors and international finance institutions’ (IFIs) perceptions and interest in contributing to the establishment of a companion, grant-funded TAF to prepare companies for fund equity investments, provide assistance in transaction structuring, supervise fund investments, assist invested companies with execution, and exit strategies

4. Preliminary analysis of the legal and regulatory environment and fund design requirements. If, and only if the first three objectives yield reasonably satisfactory results, provide an initial assessment of the legal and regulatory environment and fund design requirements.

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SECTION II: STAGES FOR THE ESTABLISHMENT OF A PRIVATE EQUITY FUND IN MONGOLIA: A ROAD MAP

Three broad favorable conditions must exist for the successful establishment and operations of a private equity venture capital fund:

• Strong deal flow, i.e., a reasonable number of high-growth companies that can benefit from private equity or quasi-equity investments to capitalize on available growth opportunities

• Favorable investors perceptions and commitment to capitalize the fund based on a favorable country risk environment and growth opportunities for business firms

• A reasonable enabling and predictable legal and regulatory environment.

The design of a potential private equity venture capital fund (its size, investment strategy, portfolio structure, fund management and administration, exit strategy, and risk mitigation measures) must be responsive to the specific country environment (companies, investors, and legal/regulatory issues).

Exhibit II-1 provides a staged approach or road map for the establishment of a private equity venture capital fund in Mongolia. The approach provides four broad stages or steps leading to the establishment of the fund:

1. Country profile and country risk and initial analysis of deal flow and investors’ interest 2. Detailed analysis of deal flow, legal and regulatory environment

3. Fund management company and grant-funded technical assistance design and preparation of Fund Offering Memorandum

4. Fund capitalization and legal and regulatory environment reform.

As indicated in Exhibit II-1, this study has completed the first stage (shown in green in the exhibit). Findings of this stage warrant proceeding with the second stage. Had the results of the study shown weak deal flow and/or lack of investors’ interest due to high risk perceptions or/and unpredictable legal and regulatory environment, no further steps or stages would need to be undertaken.

Findings from the next stage, the detailed analysis of deal flow and legal and regulatory environment will also be crucial in the decision on whether or not to proceed with the effort.

If findings from the due diligence of potential companies, sectors, and transactions, interest of companies and disclosures are not satisfactory, or the detailed analysis of the legal and regulatory environment yields insurmountable obstacles, no further work should be undertaken. Stages 3 and 4 (shown in gray color) will be undertaken only if findings from stage 2 (shown in magenta color) so warrant.

Thus, the proposed staged approach to the establishment of a private equity venture capital fund has built-in checkpoints for decision making. If findings at any point are not favorable the decision is made not to proceed. On the other hand, subsequent stages build upon findings from prior ones in a cumulative fashion.

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Section II - Page 2 Mongolian Private Equity Fund Feasibility Study

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SECTION III: CONCEPT OF PRIVATE EQUITY IN DEVELOPING COUNTRIES

In many respects, private equity investment in developing countries like Mongolia and developed countries is similar. In both settings, professional investors, say the Mongolian Private Equity Venture Capital Fund Company (to be formed), may provide equity or equity- linked capital to privately held firms. A key element for success is a commitment for ongoing involvement of the private equity investor in monitoring and technical assistance to the investee company. A second pre-condition for success is a strong legal system and functioning equity markets that allow for easy exit.

Where private equity in developing countries differs is in its implementation. There are several key differences.

A. Fund structure

The fund structure standard in developed countries is the limited partnership. The general partners are the individual venture capitalists (or an investment management firm controlled by these individuals). The partners are in charge of raising, making, monitoring, and exiting the investments. In return they are paid a management fee plus a share of the profits. But in many parts of the developing world, particularly in Asia, there has been a general lack of legal structures that allow the establishment of limited partnerships. In Mongolia, as in the Asia region, the private equity fund will have to be structured as a corporation under the Mongolian Company Law of 1999, which regulates the establishment, registration and reorganization of a company, its management and organizational structure, its shareholders’ rights and obligations, and its liquidation.

B. Funding sources

In addition to local investor and international subscription to capital, many of the sources of capital for private equity funds in developed countries are similar. Several additional parties, however, have played an important role in the raising of private equity funds in developing nations, and this method will certainly be needed to establish a fund in Mongolia. These parties have included foreign aid organizations like the Asian Development Bank, U.S.

Agency for International Development, quasi-governmental corporations like the Overseas Private Investment Corporation, and multilateral financial institutions like the International Finance Corporation, the German KFW, and the EBRD.

C. Types of investments

Private equity funds in developing nations undertake transactions familiar in the United States, including leveraged buyouts, consolidations of fragmented industries, and venture capital investments. In Mongolia, as in other developing countries, the need for medium-term capital is required to finance equipment, goods and services, which will assist businesses in developing long-term production capacity. Banks in emerging markets are almost totally asset-based lenders for the short-term, typically less than two years, thus making growth and expansion of production limited. In addition to the basic common and preferred shares, funds in emerging market make more quasi-equity investments, such as: straight term debt, convertible debt, warrants, contingent equity, and several types of transactions less common in the U.S. setting.

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Section III - Page 2 Mongolian Private Equity Fund Feasibility Study

A recent analysis of 210 private equity transactions in developing countries found that, compared to the U.S. where convertible preferred securities are ubiquitous, a much broader array of securities are employed and private equity investors often have fewer contractual protections. The choice of the investment security appears to be driven by the legal and economic circumstances of the nation and not by the private equity group. Investments employ common stock or straight debt where capital markets are robust, but in countries where capital markets are less developed, such as Mongolia and the former state-dominated economic systems of the Soviet Union, they are more likely to use preferred stock with a variety of covenants. In nations where the rule of law is less established, or undergoing reform as in Mongolia, private equity groups are unlikely to use common stock. In cases where investors own the majority of the firm's equity, the investment risk is higher, but the higher ownership stake is also an insurance against the investment risk if the company encounters difficulties¹.

D. Exiting

Perhaps the most vexing aspect of private equity investing in developing nations has been the difficulty of ‘exit.’ Proper ‘exit’ allows the realization of the capital gains, providing returns to investors and funds for operating expenses of the management company so that it can continue making additional worthy investments and be sustainable. The fortunes of private equity investors in the developed world have been largely linked to those of the market for initial public offerings (IPOs) distributed in the equity markets. Private equity investors in developing countries cannot rely on these offerings. Even in “hot markets”, where large foreign capital inflows occur, institutional funds are usually concentrated in a few of the largest corporations. Smaller and new firms typically do not attract significant institutional holdings and have much less liquidity. Consequently, private equity investors in developing countries have tended to rely on sales to portfolio firms or strategic investors. This can be problematic, however, when the number of potential buyers is small; the purchaser can exploit the private equity investor's need to exit the investment and acquire company stakes at below fair value. Restructuring the equity market in Mongolia is a high priority to enhance options for exiting.

1 Josh Lerner and Antoinette Schoar, “Transaction Structures in the Developing World,” NBER, March 2004

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SECTION IV: COUNTRY RISK AND COUNTRY PROFILE

A. Mongolian opportunity

The team believes that the country is likely to experience continued macroeconomic, political, financial and industrial development due to a number of factors including: existing legal infrastructure for a functioning market economy, strong international donor support, significant mineral resources such as gold, copper, oil, replenished livestock herds, the world’s highest quality cashmere, high tourism potential, access to the large markets of China and Russia, growing young literate workforce, and a large underemployed work force.

As a result of the demand for longer term equity investment and loans, say three to five years, the development of Mongolian private enterprise would benefit from funds provided by a private equity venture capital fund vehicle using equity and quasi-equity instruments.

Mongolia is completing the transition process to a market-based economy and the private sector accounts for 75-80% of GDP and 90% of enterprises are privately owned. GDP has potential to grow at higher rates than the current 5% annual rate, according to estimates of the Ministry of Finance and Economy (MoFE) and international financial institutions (IFIs)². Mongolians have an entrepreneurial spirit and a culture of trade. Lucrative investment exists as a result of the current planned reforms of the coalition government that took office on October 1, 2004. We believe the assets values of companies operating in the country are undervalued, although proper accounting methods and use of IAFRS are incipient.

The expansion of the capital markets and development of a limited liability equity culture may start to untangle in the country. We believe private equity could increasingly use the equity markets—potentially through the existing Mongolian Stock Exchange—to raise new capital for existing and new companies, if coupled with improvements in company disclosure and the premium valuations placed on strong corporate governance.

The new Parliament sworn in on October 1, 2004 avows intensive development of economic policy that aims to improve the legal framework to protect shareholders and foster a business environment seeking to involve business people, banks, financial institutions and citizens freely in stock market activities³. Currently, the Asian Development Bank (ADB) Third Financial Markets Reform Mission is constructing the policy matrix and recommendations for capital market sector reforms, including the recommendation for a single regulatory agency for securities, insurance and non-bank financial institutions (NBFIs), which has become the benchmark and international best practice applied to both emerging and developed capital markets.

B. Mongolia’s challenges

Although domestic market consumer demand appears strong it is hampered by few gains in productivity and disposable income. Consumer spending is fueled by an underground economy of imported goods and inward cash remittances that supplement low incomes in a high underemployment economy.

In addition, The Multi Fiber Agreement ends January 5, 2005 and the WTO has indicated this deadline will not be altered. Thus, Mongolia will lose up to 30,000 garment worker jobs subcontracted by Korean and Chinese garment companies on subcontracting arrangements.

2 National Statistics Office Bulletin

3 The Mongolian People’s Revolutionary Party Platform, May 2004

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Section IV - Page 2 Mongolian Private Equity Fund Feasibility Study

The often-severe climate conditions affect agricultural production, which accounts for 20% of GDP and the estimated 28 million animal husbandry herd accounts for 79.5% of total agricultural production. The extreme climate conditions can cause significant damages to the economy, as it happened during the winters of 1999-2001, when the country experienced a moment of crisis for its livestock due to unusual cold weather conditions⁴.

The country is landlocked and dependent on the Trans-Siberian railroad for trade with two neighbors, Russia and China. An inadequate road system connects Mongolia with China, a country with which it shares its longest borderline. The need for infrastructure upgrading in energy and public services is essential.

The scarcity of accounting skills and qualified corporate lawyers, incipient use of IAFRS, and low levels of corporate governance contribute to low levels of business transparency.

A poorly developed capital market, especially the Mongolian Stock Exchange, requires a greater enforcement of laws and the establishment of a single regulatory authority for securities, insurance, and NBFIs.

C. Economic growth

Mongolia is achieving overall macroeconomic stability, registering a 4% GDP growth rate in 2002, and a 5% GDP growth rate in 2003. After initially declining by 20% in the first transition years (1990-1993), GDP grew by 39% between 1994 and 1999. The estimated GDP growth for 2004 is 5.2%.

GDP may in fact be higher than recorded due to the size of the informal sector of the economy. Official estimates of the size of the informal economy calculate it at 13 percent of GDP; other estimates assume that its actual size is around 35% of GDP.

Mongolia’s currency is freely convertible and the USD exchange rate has been fairly stable since 1999, at around MNT 1,100-1,200 (the October 13, 2004 USD/MNT spot rate was 1,208) to the U.S. dollar⁵. Regional data analysis of other comparable transition countries (Kazakhstan, Kyrgyz Republic, Tajikistan, and Uzbekistan) that underwent similar political and economic conditions indicate that Mongolia has performed well, registering the second highest GDP per capita, after Kazakhstan, at $448, the highest savings rate of 23.7%, and the lowest inflation rate—1.6% in 2002.

D. Business environment

We believe the business and investment opportunities in Mongolia are quite good, with business registration a seemingly straightforward and inexpensive procedure. In 2003 there were over thirty (30) thousand registered enterprises⁶, and 401 listed securities on the Mongolian Stock Exchange⁷. A peculiarity of the business environment is the informal sector, which is estimated to constitute 35% of GDP—composed mostly of individual traders and enterprises.

6 MNCCI Bulletin

7 Mongolian Securities and Exchange Commission

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Mongolian Private Equity Fund Feasibility Study Section IV Page 3

The business culture is entrepreneurial in spirit and ideas. There is a rapidly growing consumer market, fast developing banking sector, and inexpensive labor market. However, a bureaucratic approach to management remains a legacy of the socialist regime, which lasted 70 years, with emphasis on a production-oriented culture rather than a customer-oriented culture.

Government influence in the economy is still manifested through state-owned enterprises although the government is committed to continuing the privatization of these companies. It is estimated that one third of companies evade some form of tax payment and two thirds of companies purportedly pay a 10% surcharge to General Department of National Taxation (GDNT) officials⁸.

The major industries, mining, cashmere, and tourism, as well as meat processing have trade groups that represent their interests. The composition of the Mongolian National Chamber of Commerce and Industry (MNCCI) membership serves as a proxy for the structure of the business sector in general, as follows: 10.3% shareholding companies and state enterprises;

84% limited liability companies; 1.8% banks and non-bank financial institutions; 2.4%

associations, agencies and private enterprises; and 1.5% individuals and cooperatives.

E. Conclusion

Mongolia is a growing market economy with political stability since the end of the Socialist era in 1989. The Mongolian private sector now generates 75-80% of GDP and more than 90% of enterprises are privately owned. The market economy is growing and actually the GDP has potential to grow at higher rates than the current 5% annual rate. Mongolia is rich in natural resources that could be used to fuel a transformation of the economy if the right policies are implemented.

Shortcomings in the business environment and legal system still need to be overcome, but prospects are good as the country benefits from significant levels of international technical assistance aid. Mongolia enjoys comparable economic and natural conditions with similar countries that have benefited from private equity investments, such as the Central Asian Republics, Bhutan, and the Pacific Basin Republics such as Fiji, Papua New Guinea (Appendix C).

We believe Mongolia’s reform process is overcoming an opaque legal and regulatory system.

In addition, conditions by the ADB and other IFIs will help reform a stagnant but operationally functional stock exchange. The establishment of a private equity venture capital fund with partial institutional sponsorship by the IFIs can become a catalyst for developing equity markets, promoting venture capital, accelerating policy reform, and strengthening the legal system.

8 ADB Private Sector Assessment for Mongolia, December 2003

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SECTION V: INVESTMENT OPPORTUNITIES: PRELIMINARY ANALYSIS OF SECTORS, POTENTIAL TRANSACTIONS AND DEAL FLOW

A. Sector Analysis

Based on field interviews with fifty-one companies during the period of September 13- October 16, 2004, we conclude that there is a sufficient number of companies and ventures with high-growth potential—deal flow—that could yield competitive returns to fund and benefit from equity and quasi-equity investments. The private equity opportunities of investment can focus on individual companies within a sector and group companies organized across several sectors in order to build a balanced and diversified portfolio with substantial growth potential. A few of the companies possess inherent ability to be market leaders and drive consolidation both nationally and regionally.

We initiated the feasibility study seeking insight on the potential deal flow and asked several commercial bank-lending officers to rank sectors with growth potential and requiring long- term capital—greater than two years⁹. The response differed little between institutions. Meat processing, telecommunications, financial services, tourism, mining service providers, health care and education (not higher education), trade and food industries were mentioned. These sectors should be analyzed more thoroughly during the next stage of the feasibility analysis for the potential establishment of a private equity venture capital fund in Mongolia.

The estimated annual sales growth rates ranked by bankers in priority sectors are in the 15- 25% range for meat processing, mining, tourism, and consumer finance sectors, which are also influenced by non-financial factors such as domestic and foreign political and economic conditions, trade quotes from Russia and China, and world commodity prices. The food industry has been attracting significant investment, and current growth is accelerating at 20- 30% annual rate. There are no reliable data on the health and education sectors; however, these essential services are being reorganized to attract private investment as a result of increased government spending in the sectors¹⁰.

Interviews with companies’ representatives provided an understanding of sector conditions, growth opportunities, and local needs concerning the functioning of equity investments. It was clear from the interviews that few companies understand the equity investment concept. We also found a sufficient number of companies and ventures with reported high growth potential—deal flow—that could yield competitive returns to the fund. This observation will need further validation through the conduct of a detailed analysis of deal flow that should be carried out during the next stage of the feasibility analysis.

A1. Mining services

Suppliers and service providers of mining machinery and equipment can represent this sector.

In the next few years, exploration and development of production in mining will remain the largest investment sector in the Mongolian economy. Investment opportunities for the fund will include drilling, chemical laboratories, training mining workers, technology upgrading, consulting mining companies, exploration information analysis, production planning, healthcare and workforce social issues, and restoration of used lands.

A2. Cashmere

This sector is one of the sectors in which Mongolians take pride. There are around ten cashmere companies in Mongolia. The planned privatization of Gobi, owned 75% by the

9 Interviews with bank officers at Anod Bank, XAC Bank, TDB Bank, Khan Bank, Chinggis Khaan Bank

10 Based on interviews with Anod Bank and TDB Bank

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Section V - Page 2 Mongolian Private Equity Fund Feasibility Study

Government and the largest company in the sector, will open up opportunities for investment in the sector. Currently, most Mongolian raw cashmere is being exported into China where Chinese companies spin and manufacture the yarn and enjoy the value-added margins from the marketing and promotion of the finished product. China and Mongolia hold approximately 60% and 30%, respectively, of the world cashmere market.

A3. Meat processing

The largest three slaughtering houses are located in Ulaanbaatar. Russia is by far the largest importer of Mongolian meat and meat products; however, 98% of the products are for domestic consumption. We interviewed three meat-processing factories in Mongolia and all have financed automated equipment through short-term bank loans. These companies’

production standards comply with international meat processing standards, operate with equipment imported from Japan, Korea, and Germany and intend to diversify their export markets.

A4. Financial sector

Subsequent to the banking crisis in 1999-2000, the Mongolian banking sector has made progress and has become healthier. Four banks have increased equity through new investment by IFIs and private investors. The banks and NBFIs have improved their management and service quality; however, there is a need to check the expansion of the NBFI growth and improve regulations. Based on our interviews, we estimate that the seven largest commercial banks have excess liquidity of approximately USD 100-120 million. The insurance industry and related financial services such as leasing are now poised to experience growth and offer attractive investment opportunities.

A5. Food processing and beverage

With the doubling of the Mongolian population to 5 million within the next twenty years, food processing and beverages will experience above average growth. As a result of private sector equity investment, there has been a consolidation within sub-sectors of the agro-processing industry, such as flour, milk, processing fruits and vegetables; however, inexpensive imports from China limit domestic expansion. Recently, a major USD 20 million investment in new imported equipment from Germany and Austria expanded the capacity of the previously state- owned beer company, and the major baked goods company has received a USD 475,000 loan from an IFI for new equipment.

A6. Healthcare

The health care industry is operating well below the demand for adequate health care services.

This underdevelopment represents a huge potential in this industry, as there is a growing need for health care services to the growing population of Mongolia, especially in Ulaanbaatar.

A7. Manufacturing

Mongolia is landlocked between two large neighbors, China and Russia, who both have a huge manufacturing base and a low cost labor force. Mongolian companies can compete with neighboring countries’ manufacturing industries by concentrating on niche, quality products with unique Mongolian characteristics.

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Mongolian Private Equity Fund Feasibility Study Section V - Page 3

A8. Tourism

Phenomenal nature alone cannot bring sufficient number of tourists into Mongolia. The country requires international standard hotels, airports, road infrastructure, tourist camps, and attractions need to be established in order for the tourism industry to expand and flourish. The industry is fragmented with many small operators of hotels, guesthouses, restaurants, and touring companies. Growth opportunities exist in the sector for savvy and capitalized operators.

A9. Media, publishing and television

Media is one of the sectors with potential for growth. Liberated from the socialist ideology, Mongolians have become more concerned with developing sources of information. There are some very promising media companies, such as cable television providers, broadcast television and publishing.

A10. Telecommunications and Internet

The sector leader in mobile communications holds 85% of market share; however, the sector has further growth potential, as there are still many Mongolians who need access to world standard telecommunication, broadband and internet services. As a result, the market leader has competition from niche providers for all services.

A11. Information technology

Due to Mongolia’s geographic and demographic features, sectors like IT, or more specifically the software industry, could have some potential. There are some promising companies in the software industry, but there is also space for new entrants. Standard Mongolian applications for vertical markets and functions such as accounting systems offer opportunities. In addition to unfulfilled market demand, this industry could benefit from prospective attention and support from Government.

A12. Education

Like new apartment construction, education is expanding rapidly. With a high level of literacy, Mongolians understand the importance of education. Many private schools of diverse quality for all levels of education have been established during the last fourteen years.

Presently, there may be a niche for higher quality education providers adhering to international standards.

A13. Trade, distribution and retail

This has been the most dynamic sector of the Mongolian economy over the last fourteen years. For instance, in 2003 and in 2004, the number of taxpayers in these sectors increased five fold and the amount of tax paid more than doubled.

B. Companies and deal flow

To assess demand for the prospective equity fund and deal flow—existence of a critical mass of high-growth potential firms—we took the following steps:

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1. In order to understand the business environment and sectors, we created a list of Mongolian holding and group companies to be analyzed within each sector; the companies with perceived high-growth potential in a particular sector were marked against the performance of the market leaders in their particular sectors.

2. A larger pool of companies was selected for ‘deal flow’ potential from among the top 100 companies in the 2002 MNCCI Top 100 list. In addition, more MNCCI member companies were added to the list on a random basis. The MNCCI information matrix included total turnover, total (reported) tax paid, number of employees, and number of new employees, and company contact information, such as CEO, telephone and fax numbers.

3. During the period from September 13 to October 16, the study team collectively, and in rare cases separately, interviewed over 51 companies. The study called for a pre- interview questionnaire process, whereby each interview was preceded with the request to complete a questionnaire (see Appendix E), which was designed to solicit general company requirements for investment capital. The questionnaire was also accompanied by a pro forma balance sheet and income statement. This method for gathering information in the Mongolian context produced no replies, with the exception of one completed questionnaire by a leading hotel, hospitality and brewery company.

4. Finally, the recorded notes taken by the study team were collated into a matrix that contained information about: (a) sector or industry; (b) financing requirements; (c) indication of a company need for long-term capital; (d) for investing companies, an assessment of interest and liquidity to invest in the fund; (e) assessment of company needs in product development, engineering, marketing, accounting, financial engineering and other technical assistance services; and (e) form of incorporation of the company to indicate its organization as a joint-stock company (JSC), limited liability company (LLC) or publicly listed company.

There are currently no published data on company financials, performance or ratings in Mongolia that would offer a suitable starting point for an analysis of deal flow. Our method of selecting companies to be interviewed was the only alternative and was supplemented by requests for referrals to similar companies in the same sector. Our methodology enabled the study team to complete at least one company interview in each sector. In most cases, we were able to have a wide selection of companies, by sector, size, and ownership structures. For instance, we analyzed MobiCom and Micom, which are both in general telecom and IT sectors, but MobiCom is private, while Micom is state-owned as a daughter company of Mongolian Telecom.

Of the fifty-one companies interviewed for the study, only one completed the company questionnaire (Appendix E) requesting information of company’s growth plans, basic balance sheet and income statement information. Although preliminary indications of deal flow are favorable, a more detailed due diligence process is required during a second stage of analysis to determine the size of a pipeline of potential transactions and what type of investments are worthwhile. These data will be required to determine the size of the fund and develop an investment strategy for a balanced portfolio.

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C. Due diligence process required for next stage

The terms of reference for this initial assessment of potential deal flow did not allow for proper due diligence. A rigorous process of review of company management and operations, market position, cost structures, audited accounts, financial projections, risks, and growth opportunities—due diligence—will need to be undertaken during the next stage.

The list of required documents for the due diligence includes, but is not limited to, the following: corporate records, business descriptions, government agencies filings and correspondence, financing documents and loan agreements, debt instruments and financing agreements, list of mortgages, liens, pledges, or other encumbrances, financial reports and strategic plans, list of all properties, agreements, contracts, and commitments, confidentiality agreements, collective bargaining agreements, licensing agreements, list of all material litigations and claims, judgments, orders, decrees, tax returns over the last three years, the marketing plan, financial reports and the strategic plan and budget, market size and share, etc.

If and when established the management company of the fund and its investment advisor, as part of the due diligence process research, investigate, evaluate and present the potential investment opportunities, participate in the negotiations for the structuring, and monitor the company’s investments during the life of the company¹¹. The applicants for investment funds will be subject to a business and legal due diligence checklist prepared by the fund management company. Although numerous facsimiles of checklists are available, for example the Central Asia – Small Enterprise Assistance Fund’s Investment Guidelines Manual, the task of the management company will apply standards for due diligence based on the information available in Mongolia.

Although the due diligence to be carried out during the next stage is no substitute for the process that the management company of the fund and its investment advisor must conduct, it should be as rigorous as it can possibly be. The concept of due diligence and its demands are fairly new in the Mongolian context and will represent a challenge for the successful completion of the next stage.

D. Financial analysis requirements

The assessment process for a private equity fund investment strategy by a Mongolian fund management company will include the standard financial analysis, including calculation of financial ratios performed on financial statements for at least two historical years. In practice, four categories of financial ratios will be calculated, including: profitability ratios such as Gross Margin, Operation Margin, Profit Before Tax Margin, Net Margin, Return On Assets, Return On Equity; liquidity ratios such as Quick Ratio (Receivables, Cash/Current Liabilities), Current Ratio (Current Assets/Current Liabilities); efficiency ratios such as Sales/Total Assets, Sales/Net Fixed Assets, Sales/Inventory, Sales/Net Receivables; and company’s leverage ratio that equals Total Liabilities/Net Worth.

In addition, company and industry sector performance indicators including sales volume, capacity utilization, gross profit margins, operational performance, fixed and variable costs analysis, market share changes (if a listed MSE company) are essential.

In developing the investment guidelines evaluation, a financial forecast for at least 5 years will be created based on a set of assumptions regarding sales growth rates, cost of sales and gross margin, operating and non-operating expenses, cash growth rates, inventory levels and growth rates, receivables and accounts payables, current liabilities, long term debt, fixed

11 Central Asian American Enterprise Fund, “Investment Guidelines Manual”, February 2000

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assets growth rates, etc. The financial model will yield a forecast income statement, balance sheet, and cash flow statement.

The IRR (Internal Rate of Return) of the investment is the benchmark financial indicator for ranking the deal flow, which is important to the private equity venture capital fund company formulation of strategy and objectives and for the investors placing equity in the fund.

The forecast financial statements will be used for the valuation of the company by applying the DCF (Discounted Cash Flow) method, or the income approach. This method involves the discounting of future cash flows and of company’s terminal value at the end of the forecast period to the present time, using the discount rate, which is a rate adjusted to the risk of the particular investment.

In addition to the income approach for evaluating a company, one could concurrently use the cost approach and the market approach to valuation. The cost approach involves the calculation of the value of the company’s Net Assets (Total Assets-Total Liabilities), after revaluating and adjusting certain assets and liabilities to market values. The market approach to company valuation consists of three methods: the comparable transaction analysis, where one looks at transaction prices of past deals involving similar companies operating in the same industry and markets; price-to-earnings multiple method, which is employed for listed companies and consists of using the median price-to-earnings multiple of similar companies;

and price-to-book multiple method, which is also employed only for listed companies.

These valuation methods will be used to estimate the company’s current equity, as well as to determine the value of the company’s equity at the time of exit from the investment.

E. Investment risks

Investing in private equity could pose significant risks to investors. Probably the most significant risk is associated with the ‘exit’ from the investment, which could be a serious risk in Mongolia, as in other countries with a similar low level of legal reform and marginal capital market activities. In order to mitigate some of the perceived exit risks, certain exit provisions can be included in the investment agreement between the private equity venture companies.

The most frequent of these provisions are the following¹²:

1. Contract specifies trade sale to a strategic buyer as exit goal, not an initial public offering

2. If exit is not reached within stated time, the firm has to pay dividends in excess of 50%

of profits

3. The private equity fund has a put option that can be triggered at any time if there are disagreements with the management

4. The private equity fund is investing alongside with a strategic buyer who might ultimately buy the firm

5. If exit is not reached within stated time, the private equity fund can put back money to parent company of the firm

6. Contract pre-specifies an “arbitrator”, for example an investment bank, in case of discrepancies between shareholders to avoid delays in courts

7. If exit is not reached within stated time, the private equity fund can put back shares at price agreed upon by at least three reputable investment banks.

12 Josh Lerner and Antoinette Schoar. “Transaction Structures in the Developing World.” NBER, March 2004

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In addition to exit risk, there are other types of risks associated with investing in private equity such as: country risk, market risk, business risk, exchange rate risk, and financial risk. The structuring of the deal can include some financial provisions that could mitigate some of these risks, as follows¹³:

1. Debt converts to equity if the firm defaults

2. Private equity fund issues debt that is backed by guarantees of the parent company of the firm

3. “Forgivable” debt: if the firm reaches certain earnings targets, loan is converted into 0% equity

4. Majority shareholder of company issues the bond, not company, to avoid political constraints

5. Government debt becomes subordinate to equity if the firm defaults.

F. Conclusions

Based on a preliminary assessment of 51 companies, we conclude that there is adequate deal flow for the establishment of a private equity venture capital fund in Mongolia.

The lack of published financial information for companies operating in Mongolia requires continued efforts to develop a proprietary database of potential investments. This can only be accomplished by original investigation similar to the methodology employed in this study. We are confident that lending banks and institutions will cooperate in the identification of growth companies. Further, several IFIs and country assistance programs have been working over the last decade to develop technical assistance programs to the private sector, particularly for SME lending. For instance, the Dutch Government and the German GTZ finance the Enterprise Restructuring Project, which currently assists 53 business clients. The client list developed since 1999 began with a prospect identification process similar to the one we used.

As the process unfolds, identification of additional prospect companies occurs by referrals.

The next stage to examine the feasibility for the establishment of a private equity venture capital fund in Mongolia should focus on a rigorous process of due diligence to scope the size and quality of a potential pipeline of transactions for the prospective fund.

Proven methodologies exist and have been used successfully to manage typical fund risks in environments similar to Mongolia. If successfully applied, these methodologies can act as a catalyst to improve company performance, corporate governance, and needed changes in the legal and regulatory environment.

13 Josh Lerner and Antoinette Schoar. “Transaction Structures in the Developing World,” NBER, March 2004

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SECTION VI: POTENTIAL FUND INVESTORS: PRELIMINARY ANALYSIS OF THEIR REQUIREMENTS AND INTEREST

A. Investment objectives

First, Mongolian private sector interests interviewed for the feasibility study were consistent in the view that a private equity fund should operate in a for-profit manner. The fund should invest in businesses that have good prospects of being commercially viable and profitable.

Moreover, the Fund should invest in businesses that are capable of meeting international competition, while creating jobs, exports, and developing the comparative advantages of Mongolia.

Second, private sector investors also agreed that, given current conditions in the Mongolian business environment, additional technical assistance would be required to assist potential investee companies in preparing for a prospective fund investment and in executing business plans post investment. Private sector investors concurred that this technical assistance would be needed to maximize the value of their investments. Access to markets, product development, marketing, improved business practices, and accounting and management systems figured prominently. Private investors also accepted that the costs associated with this technical assistance would need to be grant-financed, at least in its initial stages. Without the concurrence of donors and IFIs to support the technical assistance component, the fund would not be capable of achieving competitive commercial returns to its investors.

Third, this grant-financed technical assistance component would also act as a catalyst to develop and advocate needed changes in the legal and regulatory environment: improved corporate governance and transparency, use of IAFRS, changes in the structure and operations of the stock exchange, etc.

Fourth, it is expected that the private equity fund’s investment strategy and track record would be sufficiently strong to attract private and semi-public funds to enlarge the capital base of the fund so that it can eventually become self-sustainable.

B. Interest to invest in private equity

Since 1991, Mongolia has had a two-tier banking system serviced by commercial banks and other financial institutions. The Non-Bank Financial Institution tier continues to grow from seven operating companies in 1999 to over one hundred today. NBFIs can engage in ten different financial activities, with the majority of them involved in lending. In addition to loan activity, other activities include foreign exchange, loan guarantee insurance, leasing, and factoring and payment settlement¹⁴.

In Mongolia, private sector access to capital is quite limited because a diversified financial sector does not exist. Private enterprises depend on the banking system for sources of capital.

However, banks have underdeveloped credit assessment systems and depend on extensive use of collateral. Banks also prefer to lend on a short-term basis and limits (20% of share capital) are imposed on the amount that can be lent to each borrower. The interviews confirmed that the demand, particularly the medium-term demand, say 2-5 years is not currently being met by the financial system. Therefore, access to longer term funds, through a private equity fund, is regarded by the market place as necessary.

14 Bank of Mongolia, “Research on Main Indicators of Banks and Non-Bank Financial Institutions”

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Section VI - Page 2 Mongolian Private Equity Fund Feasibility Study

Financial intermediation is not directing capital flows to sectors and companies requiring the medium-term equity and quasi-equity to purchase equipment, goods and services to fuel their growth potential. A private equity venture fund would fill a gap in the financial intermediation process.

C. Capital availability for private equity investments

The feasibility study attempted to measure private sector “indications of interest” among the companies interviewed, which included commercial banks, NBFIs, service and manufacturing companies. This initial assessment of private investors’ interest yielded a commitment of USD 2m to capitalize the fund, contingent inter alia on IFIs’ participation as anchor investors in the fund and professional, international caliber, portfolio management of the fund.

The team also assessed indications of interest from IFIs and donors in capitalizing the fund and/or supporting a grant-financed technical assistance component. We received positive indications from major IFIs (ADB, KFW, EBRD, IFC). The Asian Development Bank expressed interest in capitalizing the fund and has initiated its internal review process for a potential commitment to the fund. ADB typically provides up to 25% of the fund capital, although it may go as high as 30%. Other IFIs expressed high interest in the fund and await publication of these findings and those of the next stage to make further decisions.

Based on these findings, the Board of Directors of OSF has agreed to commit funds to carry out the next stage, the EPRC Project will seek USAID concurrence to do the same, and ADB has tentatively agreed to participate in the due diligence process of potential investee firms to be carried out during the second stage of the feasibility analysis.

D. Systemic risks (the Mongolian Stock Exchange)

The capital market, represented by the Mongolian Stock Exchange (MSE), should normally represent a venue for private equity investment exit through an initial public offering (IPO).

MSE has still to reach its potential and become a mechanism for raising equity financing. The study was not intended to assess the condition of the MSE. However, by default several areas of concern were discussed with the Chairman and staff of the MSE. The following is a review based on the discussions¹⁵.

1. Shareholders’ concentration. As a few shareholders control a company, dividends are not paid to minority shareholders, but this is not due to financial difficulties of the company. The dividend is not paid with the intention to have discouraged minority shareholders ‘dump’ the stock and allow the large shareholders to buy shares at the discount price, and thus take control of the company.

2. Dividend distribution system. Shareholders are difficult to reach as they are geographically dispersed all over the country; this makes it difficult to disburse the dividend payments.

3. Corporate governance. Poor corporate governance of the companies leads to a lack of transparency in the market. For instance, in 2003, only 13% of all listed companies held a shareholders meeting. In 2002, only 32.7% of all listed companies submitted their financial statements to the MSE.

15 Discussions with Mr. Dorligsuren, Chairman of the Mongolian Stock Exchange, and Mr. Gundelbal, Chairman of the Securities and Exchange Commission

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Mongolian Private Equity Fund Feasibility Study Section VI Page 3

4. Insider information trading. On Jan 22, 1998, the Securities Exchange Commission amended the Securities regulation allowing securities to be traded outside of MSE.

This amendment allowed insider information trading, used by executives of companies to buy company shares 4-5 times cheaper than the stock exchange price.

5. Lack of coordination of the securities law and regulations with the market environment. As a result, minority shareholders are not protected, and company management does not listen to their voice. For instance, MSE lost USD 1 million in settlement funds as a result of failure and bankruptcy of commercial banks holding the funds. Although shareholders have recovered USD 300,000, a USD 700,000 remains outstanding.

6. Privatization of state property through the stock exchange is separate from the primary function of the exchange. The function of the MSE should be to maintain an orderly market for the buying and selling of shares to facilitate issuers, investors and intermediaries in the capital formation process. MSE is a 100% state-owned state enterprise.

7. Government role exercised by the appointment of the Board of Directors is not international best practice for a stock exchange. In effect, the Government member is the owner of the exchange.

Consequently, the MSE suffers from a lack of national and international public trust. As a result, investors and issuers are not utilizing the services of the exchange, and exchange professionals are leaving for other positions. In order to address the MSE’s issues, a few immediate steps should be undertaken:

1. Permit ‘delisting’ companies, which do not meet the Exchange requirements for annual financial statements and annual shareholder’s meeting.

2. Require payment of dividends to shareholders maintaining a bank account through the brokerage firms.

3. Amend the Securities Law of 2000 and exchange regulations, in particular the provision on off-exchange trading of listed securities, and strengthen rights of minority shareholders.

4. Change the appointment of the Board of Directors from Government appointees to private sector (including brokers/dealers and other intermediaries) interests, and ‘de- mutualize’ permitting brokers and dealers, and third party parties, such as the settlement banks to purchase interests.

5. Engage technical assistance experts to improve the operations of the exchange and intermediaries.

E. IRR and expected returns

The level of Mongolian based investors’ dilemma is twofold. As companies require investment funds to meet capital requirement, the investors require above average (benchmark) rates of return to compensate for investment risk in such companies. The investor’s opportunity to achieve rates of return greater than other instruments available in the market, say 18-19%, through an investment in a private equity fund, say 37% is attractive.

This, however, not well understood in the Mongolian market. The high, say 37% IRR, is only achievable on the ‘exit’ (sale or IPO) of the company.